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Obama, House Republicans Face Messier Fights Ahead

If you think the fight over tax rates was messy, you might want to cover your eyes.

The worst is yet to come in Washington as President Obama and Republicans in Congress play chicken after the recent soft landing on the first plateau of the fiscal cliff.

Hope for a grand bargain is gone, and neither side sees a compelling reason to compromise. Obama’s success -- at the polls and in negotiating heftier tax rates for those with high incomes -- emboldens him to dig in and try to force the rest of his second-term agenda on a divided Republican Party. But Republicans, after getting Obama to renege on his promise to make the tax hikes apply to individuals with incomes above $200,000, pledge to push back even harder over the next two years.

Markets will be jittery, the economy on edge, as key fiscal issues are resolved in piecemeal fashion, in some cases only when chaos appears inevitable.

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The ugliest fight of the year will come in the first quarter, when Congress is asked to raise the debt ceiling so the U.S. can continue to borrow money to meet its obligations. Obama wants to boost it with no strings attached. House Republicans want to trim a dollar of federal spending for every dollar of additional debt that is authorized.

If the GOP insists on cuts, Obama will ask for additional tax revenue, this time by limiting some deductions taken by corporations. Obama is willing to slice government spending by $800 billion to $1 trillion over the next 10 years, but not as payment for a debt deal. And Republicans won’t stand for limiting business write-offs unless the corporate tax rate is lowered as part of a broad package of tax code revisions.

In the end, the debt ceiling will be raised because the prospect of the U.S. defaulting and scaring off investors is too high. But don’t be surprised if the action doesn’t come in time to avoid a credit downgrade. Moody’s, one of the three major rating agencies, has already warned it will act if serious efforts to address the deficit are put off.

Meanwhile, a broad package of tax changes is out of the question in 2013, although both sides want it. Instead, with compromise out of Washington’s vocabulary, only some tinkering is likely.

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The same is true for reforming entitlement programs, such as Social Security, Medicare and Medicaid. Those programs need to be addressed, but they’ll be put on the table only as part of a broader deal to decrease the deficit. Tackling entitlements is too risky politically to take up in stand-alone bills.

There is some appetite for reducing government spending, but many details are in flux: the dollar amount of cuts, the share from defense and domestic programs, the time frame and the mechanisms for making the cuts. Again, the ratings agencies will watch very closely.

One complication: Congress will be working out details of cutting government spending over the next decade at the same time that a continuing resolution providing funding for the government this year is due to expire. If a new resolution doesn’t pass by late March, the government will have to close until an extension is approved. At this point, such a shut down can’t be ruled out.

All of this uncertainty will weigh on the U.S. economy. Companies will delay decisions about hiring and expanding and consumers will keep a tighter grip on their pocketbooks until a clear picture emerges of what this Congress and this president can accomplish.

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Don’t hold your breath for a strong 2013. GDP will grow by no more than 2%. But the result will be even more anemic if even small steps can’t be worked out in a timely fashion.